How to play bond ETFs in Bernanke’s world

Bond ETFs: How to play them in Bernanke's world

Bonds reacted very badly after the U.S. Federal Reserve signalled that its purchases of U.S. Treasuries and mortgage-backed securities will gradually be scaled back, even as an ultra-accommodative monetary policy remains in effect for the foreseeable future.

Perhaps the rout was partly as a result of what has since been described as poor communication on the Fed’s part, bringing forth some painful memories of the 1994 bond market disaster, but a U.S. capable of handling itself without continuous liquidity injections is a good thing.

And, let’s face it, broad normalization is still a ways away, gauging by the comments from central banks elsewhere, notably the European Central Bank and Bank of England.

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There may well be further yield curve steepening (yields of bonds of longer-dated maturities rising more so than shorter-maturity bonds) and overall rising rates. But let’s not for a moment forget that the extraordinary ultra-low rate environment we have been in has favoured and stoked demand for bonds.

After fixed-income investors stop feeling sorry for themselves, there are several ways ETFs can be of assistance.

Consider one-to-five-year laddered ETFs.

These ETFs are attractively priced from an MER standpoint and there is even one, the recently launched First Asset DEX 1-5 Year Laddered Government Strip Bond Index (BXF/TSX), that won’t charge you for a year.

Importantly, their duration declines for a year before being reloaded by redeploying the front end of their maturity ladder to the back end of their exposure (taking advantage of yield curve steepness in the process).

The largest such ETFs — iShares 1-5 Year Laddered Government Bond Index Fund (CLF/TSX) and 1-5 Year Laddered Corporate Bond Index Fund (CBO/TSX) — reloaded on some durations at the end of June. The result is that duration moved back up to 3.22 years for CLF vs. 2.43 years pre-roll, and 3.24 years for CBO vs. 2.4 years, and the current weighted yields to maturity now stand at 1.75% and 2.36%, respectively, compared to 1.62% and 2.17%.

Realize holding to maturity is fine, but there is an opportunity cost.

Some investors think individual bond holdings are suspended in time and price until, magically, they get their money back, while whatever happened in the world of bonds in the interim doesn’t affect them. But on a mark-to-market basis, a bond at any point will gain or lose in relation to the then-prevailing yields for bonds of similar quality and term.

If you are still somehow married to the holding-to-maturity proposition, consider target maturity bond ETFs. Both BMO and RBC Global Asset Management have a series of such ETFs.

Shorten your duration since it is the key source of interest rate risk.

The relatively recent proliferation of fixed-income ETFs allows investors to be very precise in terms of duration and underlying exposure (government, provincial, corporates, high yield, etc.). Consider a mix reflective of your risk tolerance and yield objectives, but realize there are trade-offs.

Use cash in the form of floating rate notes.

There are several ETF variations in Canada, including actively managed ones, covering Canadian as well as U.S. markets.

Prepare to no longer buy and hold fixed income.

In an environment of potentially rising yields and heightened volatility, expect to see more opportunities to trade fixed income. Sentiment at times will cause sell-offs to overshoot the level at which yields will stabilize for a time, only to reverse course and engage in similar behaviour, possibly time and time again.

Consider other ETF alternatives for fixed-income exposure.

These alternatives may be more costly, particularly those of the active variety, but consider an actively managed ETF focusing on managing duration (and possibly credit), and otherwise possibly a bond strategy ETF such as a bond barbell ETF.

Bond barbells buy short- and long-duration bonds to achieve an overall duration comparable to that of the broader bond market. A barbell strategy may outperform the broader market depending on the way the yield curve rises.

In general, consider this: All manner of interventions, particularly in the aftermath of the great financial crisis, have conspired to penalize savers, which has no doubt hampered their ability to consume. Normalization, in that regard, should be welcome, by further unwinding some of the undesirable long-term effects of excessive accommodation by monetary authorities. Let’s just hope that normalization doesn’t trigger very abnormal market behaviours.

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